Summer Slumber - Derivative Logic

Last Week: Interest rates drifted slightly higher as US equities rallied to record highs. The yield on the 10-year US Treasury note remained essentially unchanged at 2.24% while oil prices dipped. West Texas Intermediate crude fell to $48.95 a barrel from $50.30 a week ago as OPEC extended its output cap for another nine months. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), slipped to 10.30 from 10.80 last Friday.

America’s Growth Engine Motors On. The second look at first-quarter growth in the United States was somewhat brighter than the first. Gross domestic product expanded at an annual rate of 1.2%, according to the Bureau of Economic Analysis, up from an initial 0.7% reading. After revisions, consumer spending was a bit stronger than the initial report, though capital expenditures were less robust.

Fed outlines proposed plan to shrink balance sheet. Under the proposed approach, the Fed would set a gradually increasing cap on the dollar amounts of Treasury and agency securities it would allow to run off its massive $4.5-trillion balance sheet each month. The caps would be set at low levels and then raised every three months, to their fully phased-in levels. The final values of the caps would then be maintained until the size of the balance sheet was normalized.

Why you should care. The Fed has become one of the largest traders of fixed income investments and any significant change in its actions could slow its planned pace of rate hikes, disrupting markets and the economy which has only just recently shown signs of consistent growth. Of course, the Fed won’t harm the economy intentionally, but it can’t control how financial markets react to any announced change of its stimulative policies. Don’t believe it? Remember the “taper tantrum” in 2013 when US Treasury yields spiked from 1.62% to 2.60% in just two months? It could happen again.

This Week: It’s a data heavy, holiday-shortened week where the jobs report for May and the latest gauges on inflation will be the primary focus. Markets are trying to understand the disconnect between how the increasing scarcity of labor can coincide with low and falling price pressures. This week’s docket of data releases will provide clues. We’re expecting 195K new jobs for May, near the monthly average of 185K over the past year, with the unemployment rate remaining firm at 4.4%.

Outside of economic data, markets will pay close attention to the slew of scheduled speeches from Fed officials for additional details on the Fed’s plan to unwind its balance sheet. The main questions that remain surround the size of the starting and terminal reinvestment caps and the speed of transition between the two.

Take-Away: The case continues to build for a 0.25% Fed hike on June 14^th, as economic data continue on a consistently positive slant and comments from Fed officials drop a trail of clues implying a near-term hike. We’ve forecasted a June hike for several weeks now and believe we’ll see no more than one more hike this year, likely in Q3, followed by a start of the Fed’s balance sheet unwind in Q4. Until then, the the US consumer will remain the primary driver of growth, as business investment and housing slowly catch up amid a summer slumber. Trump’s fiscal reform agenda won’t contribute to economic growth in any meaningful way until 2018, and its impact will be watered down significantly.

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